6 Αυγούστου 2013

Greek Myths: "Cyprus Pays for Its Own Failures"

On August 6th the Brookings Institution circulated a collection of papers titled "Greek Myths and Reality." The publication was timed to coincide with Greek Prime Minister Samaras' visit to the US and its purpose was to discuss - and possibly debunk - several myths about Greece and its current crisis. My contribution to this collection discusses whether it is fair to say that "Cyprus Pays for Its Own Failures." Read on.

In March 2013 Cyprus
became the fourth Eurozone country to receive a rescue package from the troika
of international lenders. It was perhaps the most controversial of the four
agreements because of the “bail-in” element: for the first time, depositor
money was to be used to recapitalize banks in trouble. The idea had been
quietly discussed in policy circles for many months but its actual implementation
in Cyprus came as a surprise to most and caused a stir. The inclusion of
secured depositors in the original haircut decision was indeed a stunning
outcome that has been subject to serious criticism.

The economic principle
behind the bail-in is sound. Rather than being bailed out with state (taxpayer)
support, ailing banks must self-finance their capital shortfalls by bailing in
bondholders and – if necessary – depositors. This is a move in the right
direction, yet there are several reasons why March 15, 2013 was not the right
time to begin implementing it:

A formal
framework for bail-ins did not exist at the time and the decision was applied
in Cyprus in a haphazard and improvised manner. For example, there was no
distinction between long-term deposits earning high returns and short-term
deposits in current accounts. As a result, many companies lost large chunks of
their working capital, leading to severe liquidity problems in the daily
functioning of the economy. At least, we seem to have learned our lesson: the
draft EU directive agreed upon in June has explicit provisions to protect small
businesses.

Rules must
be clear ahead of time. People who deposited their money at the banks were not
aware that a bail-in was a policy option.

The
bail-in was applied to Cyprus’ two systemic banks and effectively decimated the
country’s banking sector.

Cypriot
banks are deposit-based and had very few outstanding bonds. As a result, the
burden fell almost exclusively on unsuspecting depositors.

There was no prior assessment of the impact of
the bail-in on the Cyprus economy.

The economic
consequences of the bail-in are nothing short of catastrophic. Total depositor
losses have been estimated at around €8.3 billion, or 46% of GDP (€17.9 billion
in 2012). The financial and business services sector that had been the most
important growth engine for the Cypriot economy for the last several years has
been crippled and there is nothing on the horizon to pick up the slack. It may
take years to rebuild the image and credibility of Cyprus and develop new
export sectors. The decision to shrink the banking sector to half its size
overnight has resulted in a liquidity crunch that will stifle growth prospects
for the short to medium term. Most analysts expect a contraction of 20-25% over
the next three years. Unemployment was already at 15% prior to the haircut and
is bound to rise well above 20%.

Did Cyprus really
deserve this? Why was such a blunt and untested instrument used with little
apparent regard for its tremendous social cost? Was there no alternative path
that would provide Cyprus with the necessary support in a manner consistent
with EU principles but without causing so much social disruption?

Ring-fencing Greece

Europe should have
shown more solidarity towards Cyprus. It could have recognized the fact that
the economic woes of Cyprus were to a large extent due to Europe’s poor
handling of the Greek crisis, including the mistimed haircut of Greek government
bonds that cost Cypriot banks €4.5 billion (25% of GDP). The prolonged
recession in Greece hurt Cypriot banks even more as they had extensive
operations in Greece. Cypriot banks in Greece were in effect Greek banks, one
of them being actually managed by a Greek group. It would have been justified
to make provisions for capitalizing the Greek operations of Cypriot banks the
same way that Greek banks were capitalized after the losses they took as a
result of the Greek haircut.

On the contrary,
Cyprus was doubly penalized. When the depositor bail-in was put on the table,
the troika insisted that deposits in Cypriot banks in Greece should be exempt.
The intent was clear. After a long and painful slog, the Greek economy was
finally beginning to turn around. The last thing the troika wanted was to see
the Greek banking system implode as a result of the bail-in of Cypriot banks.
Thus, the solution adopted was to exempt Greek deposits from the haircut. It
may have protected Greece but at the expense of depositors in Cyprus.
Furthermore, the troika insisted that Greek operations of Cypriot banks be sold
off to Greek banks, thus leading to an indirect transfer on top of the big
losses already incurred because of the crisis in Greece. Thus in trying to save
Greece and also cut off any transmission mechanism to the rest of the Eurozone,
Europe decided to offload the cost to Cyprus – and many people think it is
rather unfair.

A faulty model?

Many people have
criticized the existence within Europe of low-tax jurisdictions, such as
Cyprus, that serve as financial and business centers. Germany in particular has
long been in favor of tax harmonization across Europe. The German finance
minister, Wolfgang Schäuble, stated on several occasions that Cyprus model had
failed and the country needed to chart a new course, while French finance
minister, Pierre Moscovici, went so far as to call Cyprus “a casino economy”.

What exactly was the
Cypriot business model? In the aftermath of the Turkish invasion that
devastated the island’s economy, Cyprus decided to fashion itself as a
financial and business center. The main attraction was a low corporate tax rate
for international businesses, complemented by a good location and climate, a
common law-based legal framework and the high quality services provided by
UK-educated accountants and lawyers. This was highly successful and the sector
became the most important growth engine, especially after Cyprus joined the EU
in 2004. This growth was accompanied by a large expansion of the banking sector
to nine times GDP in 2009. The rapid expansion of the banking sector caused
problems. Armed with plentiful liquidity, the banks financed business and
consumer loans, a construction boom in Cyprus and rapid expansion abroad,
especially in Greece, where they created extensive branch networks and invested
in government bonds. Ex-ante, the expansion abroad could have been part of a
well-designed diversification strategy. Ex-post, it turned into a disaster as
exposure to the Greek economy brought the banks to their knees.

Given the outcome, it
is easy to concur with the conclusion that the model has failed (though it is
still difficult to come to terms with the “casino economy” reference). But it
is important to understand exactly where the failure lies. Cyprus failed in
letting its banking sector get too large and expand too quickly and recklessly.
This does not render the strategy of a country specializing in the provision of
business services as a failure. For the last twenty years Cyprus has invested
in building an infrastructure that is designed to serve the needs of the
international business community. It has established itself as a place where
one can receive high quality accounting, legal and other business services at
competitive rates. Many other countries, including several European ones, have
followed similar strategies. There is nothing legally or morally wrong with
being a business center, as long as the rules are followed and the banks are
kept under tight control.

Did Cyprus follow the
rules? In the months leading up to the March 2013 decision, the German press
painted a picture of Cyprus as a laundering center for the ill-gotten gains of
Russian oligarchs. This created a negative political climate and provided the
moral justification for the country’s harsh treatment. Is there any truth to
these allegations? Cyprus had in fact acquired a bad reputation for
money-laundering in the 1990s. But in preparing for EU accession, it completely
revamped its regulatory framework to meet European standards. International
organizations like Moneyval rated Cyprus equally high with many other European
countries for its anti-money laundering (AML) procedures. A more in-depth
investigation specially commissioned by the troika pointed out weaknesses in
the implementation of AML procedures in Cyprus but did not uncover anything
that would justify shutting down the country’s international business sector.

Cyprus is perhaps
paying for old sins and for electoral brinksmanship in other countries. The
irony is that by recapitalizing the Bank of Cyprus using depositor money, the
Eurogroup has handed ownership of the bank to its big depositors - purportedly
those same Russian oligarchs! In reality, the vast majority of Russians with
money in Cyprus are said to be owners of small and medium sized businesses
rather than oligarchs (should we call them polyarchs?), while big depositors
include many Cypriot pension funds, provident funds, and 401k-type investment
plans who saw their savings wiped out.

Too high a price

Cyprus has made many
mistakes. It allowed its banking sector to get too large and to expand quickly
and recklessly abroad. It indulged in a decade of over-borrowing and
over-consumption. When the international crisis first hit in 2008, it failed to
appreciate the extent of the possible repercussions. Even after the Greek debt
restructuring, the Cypriot government seemed oblivious to the blatantly obvious
and failed to take any meaningful corrective action.

It is now time to pay
the bill for these mistakes. This is perfectly acceptable, except that the bill
is unjustifiably high. Cyprus is not paying just for its own mistakes. It is
paying for a series of policy mistakes committed by the EU over the handling of
the debt crisis. It is paying for the fact that it is small and thus can serve
both as a testing ground and as an example to other profligate countries. This
may be an instructive tool and an effective disciplining approach, but it
hardly abides by the principles of fairness and solidarity espoused by the
European Union. As it watches yet another European country sink into
depression, the EU needs to take a long, hard look in the mirror.